Synthetic greater fools

Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were “losers at the start”. Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, “[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.” Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here’s another explanation, on the buy-side.

Do you remember the “greater fool” theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and “fundamental” valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a “greater fool”, would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play “double-or-nothing” indefinitely, did very, very well for themselves.

At first blush, today’s markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not “institutions” that buy this paper, but managers who are paid for performance. And from a manager’s perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to “earn” money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime’s wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A “safe” position, from a manager’s perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague “systemic” problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and “diffusing” risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.

The Bear and the Dragon

Gather ’round ye cassandras and dark oracles, nigh the time is come! The wounded bear roars and writhes, and surely, surely! his claws at last will prick the green tumescence of the credit pimple, and a pustulence of default and devaluation will gurgle across the land!

Or not. The crisis at two hedge funds managed by Bear Stearns has all the markings of a systemic-crisis-threatening event. (If you’ve not been following, tsk. Naked Capitalism has been doing a phenomenal job covering the story.) But I don’t think anything bad is going to happen, because the bear and his friends in the forest (hedgehogs?) are, ultimately, protected by the Dragon.

First let’s review the what happened. Bear managed a hedge fund that made leveraged bets in illiquid CDOs backed by subprime mortgages. That was a winning strategy for a long time, so, by popular demand, Bear opened a second fund taking on even more (um, “enhanced”) leverage to reap those juicy mortgage yields. But, things have gone suddenly wrong in mortgageland, and the funds were forced to inform investors that they had lost a lot of money. Investors found themselves locked in, with lenders demanding that the funds put up more collateral or face forced liquidation of their assets.

Forced liquidation would have been, um, bad, from a green-pustulence-flowing-in-the-streets perspective. There are lots of hedge funds holding illiquid, hard-to-value synthetic debt based on iffy mortgages. With help from debt-rating agencies, fund managers are employing the strategy Wile E. Coyote would have followed, if he were smart enough to understand Gaussian copulas and stuff. It’s called “Don’t Look Down!” Since exotic securities don’t trade very often, there is no clear market price, no clear value to which funds have to “mark” their portfolios. So hedge fund managers use models to make educated guesses of what their securities are worth. Since managers earn fees by seeming to perform well, they tend to use models that, lo and behold, spit out optimistic, all-is-well valuations of their portfolios. However, a “fire sale” at Bear would put Wall Street Panglossians under pressure, as all of a sudden market prices, not very nice market prices, would be attached to securities quite similar to the ones in their own portfolios.

Let’s understand what we mean by “pressure” here. Imagine you’re a hedge fund manager sitting on a pile of leveraged rocket science that you privately think has lost much of its value. You have two choices. You can use a model that captures your intuition, and mark down the assets, forfeiting any performance fees and your seven figure job too. Or you can hold tight, keep the faith. If you make it to the end of the year, you get a big performance fee, which you get to keep even your faith turns out to have been misplaced and your investors lose money. This is a no-brainer, right? Keep da faith!

But there is a wrinkle. If you take that hefty bonus, but you really did know that the fund didn’t perform as advertised, well, there are technical terms for that. Theft. Fraud. The language of high finance can be arcane, but maybe you get my drift here. Currently hedge funds are relying on safety in numbers. If “industry best practice” is to value CDOs and XYZPDQs optimistically, then, hey, you can’t be faulted for following “industry best practice”, can you? But if anyone can make it stick that you knew, or should have known, your portfolio was trash… well, that’s bad. Plausible deniability is the whole game here. If very low asset prices from some hedge-fund yard sale get published in the Wall Street Journal, some fund manager might get nervous, and mark down his assets too, bragging about “integrity” and other unprofitable hogwash. All of a sudden, “industry best practice” is what he’s doing, and you’ve got to follow along or take a chance on Sing Sing. With each capitulation, each markdown, investors get more and more nervous, more and more inclined to remove funds, forcing more sales, liquidations, lower prices, a death spiral, the Great Depression.

There might have been some danger of this sort of thing happening on Friday, but the danger has passed. Bear put up 3.2B of its own money to save one of its funds. (Well-collateralized repo financing we are told, but if the collateral is trash… let’s just call it a “mezzanine tranche”.) That seems to have been enough to persuade creditors, some of whom had threatened to pull the plug abruptly and start selling, to give Bear some space to work out the debts of the other (more toxic) fund at, um, a measured pace. Does that matter? After all, if the assets are impaired, fire sale or no, they’re not going to fetch a good price, right? It might go slo-mo, but the same scenario should unfold eventually, no?

I don’t think so. Here’s where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States’ current account deficits were unsustainable, that developing countries like China would not be able to fund America’s huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China’s central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China’s Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.

Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are “orderly”, I think China will find it in its interest to be a “bagholder of last resort”, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That’s not really true, but we’ll let it go here.) China won’t buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.

Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let’s put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.

The Economics of Subsidy

Here’s Dani Rodrik on export subsidies:

[T]he economic case for countervailing duties is extremely weak. (The standard economist’s line is that you should respond to other countries’ export subsidies by sending them a thank-you note, not by shooting yourself in the foot in return.) But presumably there is some (second-best or political) reason why WTO rules sanction countervailing against subsidies.

This paragraph struck me as delightfully odd. Two facts that don’t get along are stuck together and left to eye one another warily:

  1. Export subsidies are so widely perceived as harmful to recipient nations that the World Trade Organization, a body whose “overriding purpose is to help trade flow as freely as possible“, countenances trade barriers to combat them.
  2. Standard economics suggests that an export subsidy represents a windfall to recipient nations, an opportunity and a boon, not a harm at all.

What gives? In the wide and wonderful field of economics, is there no room at all for the commonplace observation that a subsidy often does harm to its recipient?

In everyday life, we know that in order to do more good than harm with a subsidy, we often need to make predictions about how the recipient will respond to the grant. Offering to cover an 18-year-old’s college tuition is very different than cutting a no-strings-attached check, even if the money’s the same either way. Some 18-year-olds would be better off with the cash than a paternalistic tuition grant. But most probably would not be.

This sort of analysis is a priori out of bounds to any economics that views people as rational maximizers. If the best thing a teenager could do with a couple hundred thousand dollars is to turn it into a four-year annuity for college, the utility maximizing teenager will do that. If she chooses to do something else, by revealed preference, that must be the better choice. Right? No.

We reject this kind of reasoning in real-life, even when considering fully competent adults. If we can understand why it is not nice to put a slice of apple pie on a struggling dieter’s plate, or why very low introductory “teaser rates” on a home mortgage can entice borrowers into dangerous situations, why can’t we understand that certain kinds of subsidies increase the likelihood an economy will trade short-term gains for long-term harms? Of course we do understand that, even the WTO understands it, but economics as a discipline has a remarkably hard time coming to terms with the intuition. Human choice is endogenous and stochastic, not exogenous and rationally determined.

There’s an important distinction between noting that certain subsidies increase the likelihood of bad outcomes for a recipient and suggesting that the provider of a subsidy is therefore culpable for the outcomes. It’s usually counterproductive to blame someone else’s generosity for ones own poor decisions, even if the generosity was cynical and the bad consequences were anticipated by the donor. A crucial feature of subsidy is that it may be refused. A dieter may prefer not to be tempted by the sights and smells of heaven à la mode. But if a host insists on offering, she should still refuse the pie. At the national level, things are more complicated. An export subsidy likely to cause long-term harm to a nation may unambiguously benefit some individuals. How does a nation “refuse the pie”?

By enacting countervailing import tariffs, according the the WTO. But that seems like poor table manners, like raising a middle finger when a simple “No, thank you” would do. If only they could get over the logic of “might as well eat”, economists would have little trouble devising polite but firm ways of saying no.

We’d still miss the pie. But maybe that’s for the best.

Felix Salmon on Inflation

Felix Salmon has a very nice take on core vs headline inflation:

[I]t does seem clear that there is a significant and positive gap emerging between headline inflation (which includes food and energy prices) and core inflation (which strips them out). The gap is essentially a tax on poverty.

The poor spend a much larger percentage of their income on food and energy than the rich do, and they don’t benefit much from large drops in microprocessor prices. If this gap is sustained going forwards, then the real income of the poor is going to be eroded by inflation much more quickly than the real income of the rich. Not that there’s much the poor can do about it. The rich, on the other hand, have the Federal Reserve on their side, since the Fed targets the core inflation rate.

Combine this analysis with the Fed’s particular vigilance against rising wage costs (the only thing that helps poorer people get richer) and you might wonder whether the Fed is a beneficent, technocratic manager of monetary policy, or a covert agent of class warfare against the poor.

OK. That’s a bit much. There are very good reasons for stripping out food and energy prices out of inflation measures, and paying special attention to wages. Inflation is bad not because some particular price level is ideal, but because some prices are sticky. A rapidly changing general price level will leave many prices glued to non-equilibrium values, impairing price signals in the economy and harming efficiency. Food and energy are not stripped out just because they are volatile. (There are lots of techniques for smoothing or averaging time series. Trimmed means and medians can be used to get a smoother view of distinct monthly datapoints.) Food and energy are left out of the core because their prices are not sticky, so price changes in these sectors are unlikely to distort the real economy.

Similarly, wages are particularly sticky, and can almost never go down in nominal terms. When wages rise above equilibrium levels, the Fed finds itself between a rock and a hard place. If it maintains price stability, overpriced wage levels exert a drag on the real economy. To get the economy chugging at full potential, the Fed will have to “accommodate” some inflation to bring wages back down in real terms. But a jump in the price-level may create self-fulfilling inflation expectations among workers and firms, leading to a “wage-price spiral” that is hard to slow down once it gets going. It’s better for everyone, therefore, if the Fed is diligent about not letting wages get ahead of themselves to begin with.

That’s all well and good. But aren’t house prices downward-sticky too? There are indeed very good reasons for the Fed to pay less attention to food and energy, and very much attention to wage levels.

But isn’t it odd that right and proper theory somehow requires that the Fed to tilt the playing field towards capital and the already wealthy, and to fight any increase in the bargaining power of people who neither speculate nor to borrow, but who work every day and live off the proceeds?

Note: I’m pretty sure I first read the justification outlined above for stripping food and energy from core measures somewhere on David Altig’s excellent macroblog. I can’t find the specific post, but alotta love to him anyway. (It’s possible, since I can’t find the post, that I’m misattributing this argument to Altig. If I am, sincere apologies, but good vibes anyway for his very thoughtful blog.)

Update: It looks like the argument about stripping food and energy from core inflation may have been cribbed from Mark Thoma rather than David Altig. All the brilliant econobloggers kind of look the same to me. Anyway, see this post by Mark Thoma.

Update History:
  • 15-June-2007, 10:00 p.m. EDT: One really should get ones attributions straight before posting. Anyway, replaced my vague attribution to David Altig with a specific attribution to a Mark Thoma post.
  • 15-June-2007, 10:25 p.m. EDT: Added a comma.
  • 16-June-2007, 12:15 a.m. EDT: Tightened up the text a bit (last paragraph of the main essay).

Orthodox Economics: Descriptive, or Tranformative?

Like you, dear reader, I was transfixed by last week’s lovely debate on heterodox economics. One of the subtexts of that conversation was a simple question: Why can’t we all just get along? Nearly all the heretics conceded that orthodox economics is useful and interesting. The defenders-of-the-one-true-faith generally conceded that there are deep, unresolved mismatches between fundamental tenets of mainstream economics and how people actually behave. In fact, as the orthodox-but-still-hip Dani Rodrik suggested that the usefulness of orthodox economics comes from exploring precisely how and why neoclassical fairy tales don’t come true.

But if that’s the case, it seems odd that one admittedly broken paradigm would so ruthlessly dominate the profession. Why is it that, as Thomas Palley notes

Orthodox lefties (e.g. DeLong, Krugman, and Rodrik) believe the Arrow-Debreu framework not only provides a good starting point for thinking about the economy, [but that] it is the only point.

After all, there are a lot of flawed approaches to economics that we could use to help us think about what we cannot understand. Why is the neoclassical error so special that, as Max Sawicky points out

The duty of orthodoxy is clear: deny departmental positions and resources to inferior research programs and purify the top journals of incorrect thinking, all understood as maintaining high standards. After you deny them professional positions, standing, resources, and exposure, the only thing worse that could be done is to commit errant economists to mental institutions.

That characterization may be over the top. But even defenders of the mainstream concede that pursuing other approaches is an uphill battle. Here’s Mark Thoma:

If you choose the heterodox path, you will be on the outside, and you need to understand that going in. You might get lucky and gain respect over time, and if you make a really big splash economics departments may then start hiring people in the area, but don’t expect that because it’s unlikely to happen. At best, you might become part of a small group with common ideas and interests, but larger acceptance will be elusive (though not impossible). It will be harder to publish, your colleagues will wonder why you’ve drifted so far out of the mainstream, the work you do publish won’t get the respect you think it deserves either within your department or in the profession more generally — it’s likely to be a frustrating experience on a lot of fronts. That’s how it’s going to be.

Why? What’s so special about one broken framework that those who choose other approaches must toil like monks under a vow of obscurity?

There are lots of possible answers, many of which were hashed over last week. But it strikes me that perhaps we are all missing the point. Perhaps orthodox economics isn’t even trying to describe how the world works. Perhaps the project is really about how the world should work. If life can imitate art, why couldn’t life imitate a model?

Here’s a famous bit from Marx:

The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound man to his “natural superiors”, and has left no other nexus between people than naked self-interest, than callous “cash payment”. It has drowned out the most heavenly ecstacies of religious fervor, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation.

So, as a writer, this guy is a bit overwrought. But there is a powerful idea here. Marx does not claim that human beings are “naturally” given to egotistical calculation. Instead he claims that however “man” might have been, social change is possible that transforms him into what we now refer to as a “rational maximizer”. The assumptions of neoclassical economics are not a priori true in this view, but they can be made true.

Think about that. Mull it over. And while you do, let a photomontage play upon your inner eye. Here’s Adam Smith, with his beneficient invisible hand. Now David Ricardo is explaining why selfish nations trade, and how trade has no losers but makes everybody better off, and interdependent. Slip forward in time and admire the elegant theorems of Coase, Arrow, and Debreu. This is a happy story. This is a great story. If only Marx were right, if only human beings could become something like efficient, selfish, rational maximizers, then we can prove, prove, that we would end up with the best of all possible worlds, by a certain definition.

Viewed in this light, the vehemence of the orthodox project makes a certain sense. It is not interesting to harp on the fact that people are not as they ought to be, and therefore our theorems and models don’t accurately describe the world. We know that. We build models to make sense of the deviations, so we can correct the “market failure”, the human flaw. Our job is not to describe the world as it is, but to understand how it is different from what it ought to be, and to fix it. The “MIT Keynesians” are open to using government to remedy human error, while more traditional neoclassicals view the Leviathan as a wildcard too large and dangerous to risk. They imagine that some more decentralized process — something more like the dynamic Marx himself described — could effect the necessary transformation. Both groups agree, though, that the project is to make the hopeful logic of economics actually work in this messy and often hopeless world.

What would a “heterodox economist” have to offer here? Those weird lefties who, contra Marx, think that Homo Economicus is so unreal as to be irrelevant, who view the world through prisms of power, institution, race, caste, or gender, amount to nothing more or less than fatalists. It is not the accuracy of alternative descriptions that is at issue, but where they lead — conflict, grievance, and struggle. For heterodox economists the end of history is where it began, nature red in tooth and claw.

By the way, I write not to bury but to praise. I think Marx was right about the transformational nature of capitalism, about its capacity to hew egotistical calculators out of flesh, blood, and claw. I sit at my desk surrounded by health insurance forms, bank and brokerage statements, tax documents. My colleagues come from everywhere, from I don’t know where, I can’t keep track of whether a hundred years ago their grandparents tried to kill my grandparents or vice versa. The orthodox, or bourgeois, project has succeeded marvelously, and for all that has been lost (and much has been lost), I am glad of it. I’ll go with the neoclassicals or with the MIT Keynesians, whatever. Whatever works.

But (more Marx) orthodox economics contains the seeds of its own destruction if it fails to recognize the degree of its own delusion. When Ricardo’s lovely story is not in fact working out, we should admit that to ourselves. Our goal is to create the preconditions whereby our optimistic models would actually predict. If we have failed to do that, then clinging to the behaviors that our models prescribe may lead to outcomes, um, inconsistent with general welfare. We may have to fly by the seat of our pants for a while, and then try again to get it — that is, us — right.

Bloggers mentioned:

Update History:
  • 15-June-2007, 09:20 p.m. EDT: In light of this, added attributory links, for various allusions. “Leviathan” alludes to Thomas Hobbes, and “nature red in tooth and claw” is taken from In Memoriam by Tennyson.

Nations are places

It’s obvious that nations are places, right? But somehow that fact is lost in much of the debate over trade and immigration. Instead, the argument usually goes something like this: Trade and immigration help some people and hurt others, though gains should exceed losses in the aggregate. How do we weigh benefits to winners against harms to losers?

But trade and immigration policy don’t just affect people. They affect places. Why should that matter? Places experience neither pleasure nor pain. Places do not love. If you prick them, they do not bleed. Isn’t it right that economists ignore places, and focus on how policy affects human beings?

No, it is not right. It is dangerously obtuse. You will often hear economists laud the indirect benefits of market economies. Where markets flourish, virtues such as tolerance, diligence, entrepreneurialism, and creativity thrive as well. Markets depend upon trust, and market-based societies tend to develop unusually strong habits of trust between unrelated strangers, as well as institutions for punishing violations of good faith impartially. Where there are markets, there is industry, human capacities are exercised, and profitable collaborations are encouraged. Markets promote wealth, and affluence leads to beautiful private spaces, and then beautiful neighborhoods and vibrant cities for all. Markets create incentives for human beings to improve themselves even more than their homes, filling the world with interesting, passionate, talented people.

These indirect effects of economic activity amount to what I’ll call “emergent public goods”. These are distinct from (but complementary to) traditional public goods, like roads and parks, that governments explicitly purchase. But here’s the thing: In successful nations, access to emergent public goods is the single greatest asset most citizens have. Why would so many people from broken countries give up whatever wealth they’ve accumulated to live in the United States or Western Europe? Because access to the public goods on offer in those places is worth more than all that they own, and more than the awfulness of having to start over in a strange place, confused, mute, and alien. Even when direct public goods are withheld (for example, from illegal immigrants), emergent goods flow like air to everyone, simply by virtue of where they are. “Opportunity”, the fudge by which economists turn the pain immigrants endure into net-present-value enhancing rationality, is nothing more than an emergent public good. And opportunity, like other emergent public goods, is attached to place.

I am (very reluctantly) trade-skeptical at the moment, and not because I think that the United States’ present aggregate losses are larger than its gains from trade. On the contrary, I wish to see Americans’ current debt-for-goods trade stop despite any aggregate gains, because I think that this trade pattern is undermining America’s capacity to sustain and enlarge its portfolio of public goods. It is not that unbalanced trade is hurting people (although of course it is hurting some and helping others). Unbalanced trade is hurting the place, and the place, the privilege of living in this extraordinary country, is the most important asset Americans have, however long they’ve lived here.

Trade in services (i.e. outsourcing) and immigration have broadly similar distributional effects. There is little economic difference between a programmer in India writing code very cheaply and the same individual coming to the United States and doing the work for less than the local prevailing wage. Nevertheless, I’m inclined to favor the immigration, but not the trade, under present circumstances. Why? Because when a worker immigrates, the productive economic activity happens here, in this place, and that is oxygen to America’s portfolio of public goods. When Americans trade debt for services performed overseas, the good side effects of human industry happen somewhere else, and the bad side effects of accumulating debt happen here. It’s all the same to the people. But unbalanced trade hurts the place.

Nations are places. Quality of place is incredibly valuable, and potentially fragile. Any consideration of trade or immigration that tallies up gains and harms to people is incomplete if it fails to take into account how different economic arrangements affect the quality of places.

Update History:
  • 04-June-2007, 02:25 p.m. EDT: I’ve cleaned up several small grammatical errors and tightened the text a bit since first posting.

Carbon Tax & Trade

Would it be possible to design a carbon tax that the public would enthusiastically support? That would be progressive, rather than regressive, imposing greater costs on the rich than the poor? Is it politically possible to strictly limit the total amount of carbon emitted, without rewarding past polluters with windfall emissions permits? Yes, it is. And it’s fun! Politicians — Here’s an opportunity to give money to your constituents, and save the world too! It works like this:

First, enact a carbon tax. Nothing fancy here, just your usual I’m-Greg-Mankiw-Wanna-Join-My-Club? “Pigouvian” carbon tax. Embedded in what drivers pay at the pump, added as yet another surcharge to heat and utility bills, would be a new Federal tax on carbon sold or used as fuel. That was easy.

Unfortunately, a carbon tax is regressive. It imposes disproportionate burden on the poor, as the higher cost of driving to work and heating a home takes a much bigger bite out of a burger-flipper’s paycheck than a hedge-fund manager’s “capital gain”.

But, here’s a trick. Just as flattish taxes are regressive, flattish subsidies are progressive. So, when we enact the carbon tax, we grant citizens the right to a refund of the tax on a fixed quantity of carbon consumed. We distribute those refunds equally among all taxpaying US citizens annually. And, we permit citizens to sell any refunds they won’t need to use.

Suppose, in the beginning, we set the amount of refunds to be equal to the total expected carbon tax, given 2007 US carbon consumption. This seems dumb, right? In the aggregate, we’ve just created a system whereby the government collects a tax and sends it right back out again, exacting a net cost of zero from the private sector for its profligate use of carbon. All the government has done is caused transfers within the private sector. Yes. But from whom to whom? Light users of carbon end up receiving cash, from the excess permits they sell, while gas-guzzle-monsters pay up! That’s likely to mean that most poorer people earn cash from their allotment, paid for by the people whose Hummers they can’t see over. Moreover, note that our refunds are distributed only to taxpaying humans, not to businesses, but businesses are still subject to the tax, and can purchase refunds. That means that on net, the government will have underwritten a transfer from businesses to voters households. The vast majority of human beings will see ka-ching positive net wealth from this scheme, without any cost to the government. People who conserve more will earn more, people who conserve less will earn less, or even have to pay. Businesses will buy refunds from households, so long as the cost of the refund is less than the cost of the tax. When there are no more refunds left to buy — when aggregate carbon consumption exceeds the refund allotted — some users will have to pay the tax outright, at whatever rate the government has set.

Now of course a tax on business is indirectly a tax on households. But this is a tax businesses can minimize, by reducing their carbon footprint. That is, after all, the point, to change behavior. Plus, taxing indirectly via businesses, rather than taxing households directly, increases the progressiveness of a tax. Not all costs are passed on to consumers. Some costs take a bite out of profits, harming relatively well-off capital-owners disproportionately. (That’s why we have things like corporate taxes.)

The political economy of this scheme is interesting. Since this is a tax that creates an income for most voters (earned, of course, via parsimonious use of carbon), voters might be expected to support increases in the level of the carbon tax, as this increases the value of their refunds. Increasing the tax level faster than the refund allotment makes most voters richer, and helps save the world. It also creates strong incentives for businesses to conserve carbon. As the tax level gradually grows very large, the scheme converges to a cap-and-trade, because it becomes prohibitively expensive for anyone to pay the unrefunded tax.

Would this scheme be hard to implement? Not terribly. Remember, we begin with a simple carbon tax, and we start small and build gradually, so that the refund infrastructure has time to evolve. For a while, lots of refunds would go unused. (They needn’t expire quickly.) The government maintains a system of accounts, linked to taxpayer IDs, and encourages private-sector actors to implement trading systems. Carbon consumers claim refunds by submitting proof of taxes paid (bills and receipts), which the government reimburses with a deduction from the claimant’s refund account. The process would be quite analogous to the value-added tax reimbursements of businesses apply for in many countries. Consumers who are too busy or disorganized to deal with the paperwork can just sell their refunds and pay the taxes (though they lose some by doing this). Initially, a small industry would spring up to ease the process of claiming refunds, in exchange for a cut. Eventually businesses would find competitive advantage in automating the process. Gas stations, for example, would have every incentive to electronically submit claims on behalf of customers, so that customers see a discount right at the pump. Fraud would be an issue, as it always is. There would be problems, scandals, and solutions.

There’s been a lot of debate among the pious, which is more godly, carbon tax, or cap-and-trade? Here’s a scheme that starts as a carbon tax and evolves into a cap-and-trade, that creates incentives for consumers, businesses, and politicians to reduce carbon use, that can be implemented gradually, that doesn’t reward past polluters, and that leans just a little bit against inequality. What do you think?

Update: For a similar but much simpler idea, see Softening the Impact of Carbon Taxes. The paper proposes a fixed cash rebate of carbon taxes collected, rather than tradable refunds. Thanks to commenter (and author) Dan for pointing this out.

This idea was inspired by Martin Feldstein’s Tradeable Gas Rights proposal, via Mark Thoma. I first suggested something like this as a comment to Mark’s post.

Update History:
  • 26-May-2007, 08:35 p.m. EDT: Added update linking to Carbon Tax Center whitepaper.

Don’t blame China’s leadership, blame America’s.

Robert Samuelson describes China’s trade policies as “predatory” and “mercantilistic”. Thomas Palley writes that “individual countries can strategically game the [international trading] system for their benefit at the expense of others. That is why the system needs rules and a spirit of cooperation… China has been admitted into the system but it is unwilling to play by the rules, in letter or spirit.” I agree.

But. China’s leadership has engineered the largest, fastest boom in all of human history, which has lifted hundreds of millions of people out of extreme poverty. They have retained legitimacy and control over a fractious, nearly ungovernable nation, despite capitalist-democratic triumphalism that loudly proclaimed their style of governance a relic. They have advanced China’s national interest, and their own interest in clinging to power, brilliantly.

In doing so they have broken some rules. Well, knock me over with a feather. Nations play hardball with one another. When confronted with a choice — huge welfare gains for their citizens and huge personal benefits for themselves, or some genteel rules set by nations that have historically mistreated them — China’s rulers opted to look out for number one. Incentives matter. What would an economist expect?

I dislike China’s form of government, its authoritarianism, its brutality, its disrespect for liberty and free expression. But in terms of industrial and economic policy, the country is kicking ass and taking names. While it remains to be seen how sustainable its achievements are, China’s leadership deserves admiration more than condemnation for its trade policy. They have not played nice. They have done what nations do, and done it well. They have acted in their own, and their citizens’, self-interest.

The United States, on the other hand, has not acted admirably. Games, even the very high-stakes games played between nations, involve more than one player. It has been obvious for several years that China has been acting mercantilistically, that its government has been taxing workers to subsidize exports, undercutting American industry while buying political support in the US with easy credit and low, low prices. This has not been rocket science. Yet America has done nothing but mildly complain.

The United States needn’t have stood helplessly by and watched China cheat. It might have acted. No, it is not rampant American consumerism or any other mushy cultural deficiency that is to blame. Consumers in the United States have been quite rational, buying artificially cheap products offered with very generous financing. Demand curves are downward sloping. But when individually rational behavior adds up to collectively poor results, it is the job of governments to change the incentives.

The US government has always had it in its power to bring trade into balance. It has the power enact tariffs, grant subsidies, and control the flow of foreign capital. America’s central bank could “sterilize” all the excess credit provided by dollar-pegging exporters by selling US bonds and purchasing diversified portfolios of foreign debt. Even the credible threat of any of these policies might have persuaded China that it was more in its interest to “play by the rules” than to flout them. But the self-interest of the bought, combined with free trade as ideology, has prevented any of that from happening.

America’s large deficits can’t persist indefinitely. As Thomas Palley is right to note, America’s choices are “pay now, or pay more later.” Breaking America’s China “addiction” (as Paul Krugman put it) will be difficult. But it does need to happen, “the sooner the better.”

China is well on its way to becoming the world’s largest economy, and its growing prosperity has been earned, not stolen. The US need not, and ought not, start a trade war with China. There is no need to single out China at all. The United States should simply take policy action to get its own house in order. It should force its trade into overall balance quickly, and endure whatever pain and dislocation that will entail. There are many workable policy choices. (I remain partial to Warren Buffett’s proposal.)

In any hopeful future, the United States and China are both large, vibrant economies, and good friends. Culturally and commercially, China and the United States have a great deal to offer one another. China has played rough. So what. The US should congratulate China for its successes thus far, and wish it the best in the future. At the same time, policymakers should make clear that the rules of the game have changed, and that while America eagerly embraces globalization and interdependence, it will not accept asymmetrical relationships of dependence. Even if that means violating some rules of “free trade”.

Thanks to Mark Thoma for calling attention to the Robert Samuelson and Paul Krugman pieces.

Ricardo vs. Markowitz

Economics has its founding fathers, like Adam Smith and David Ricardo. If list of greats were compiled for finance, Harry Markowitz would number among them. Markowitz helped invent Model Portfolio Theory, a mathematically elegant approach to optimizing investment portfolios that considers not only how well one expects investments to do, but also how certain one is of ones judgments, and the typical inter-relationships between “surprises” in different investments.

Markowitz’s theory of investment and Ricardo’s theory of trade are meant for very different domains, but the contrast between them is striking. Ricardo teaches that nations should determine their comparative advantage, and specialize in that, trading for what they do not produce most efficiently. Markowitz suggests that investors beware the temptation of specialization, and diversify even into apparently inferior investments to limit risk. Both are revered. What explains the difference?

Nations, after all, are investors, in the aggregate. Specializing in manufacturing or software or wine or cloth entail vastly different portfolios of fixed structures and human training. And investors, like nations, have comparative advantages. Consider a venture capitalist, or an “angel” investor. Each faces different investment opportunity sets, determined by who they know and the localities or domains in which they invest. Every investment has an opportunity cost (the expected return on other investments). Using return estimates alone, most investors would find that choosing one or a very few investments would uniquely maximize expected return, net the cost of foregone opportunities. The situation of a nation that can trade for what it does not produce is broadly similar to that of an investor, for whom a high return in a software venture yields specie that can be used to purchase food, shelter, and yachts. (The no-trade analogy would be an investor whose profits at a stocking factory would have to be taken in the form of inedible socks.)

So, should nations and investors both specialize? Or both diversify? Or should they behave differently, and if so why? From an investment perspective, the question would turn on two considerations, uncertainty and the optimal locus for diversification. Uncertainty is the easiest factor: An investor who can perfectly predict the real returns on investments should absolutely not diversify, even under Markowitz’s theory. Ricardo took the comparative advantages — that is the relative investment returns — of nations as fixed and given. Under these circumstances, Markowitz would agree that specialization is the way to go. But how good are nations, really, at knowing their comparative advantages? And even when they choose correctly, how likely is it that changes in circumstance or random surprises render judgements inaccurate? The greater the uncertainty, either of estimation or environment, the greater the case that nations should diversify.

A second question hinges on who is best placed to diversify. In the 1960s, it became fashionable among corporations to form “conglomerates”, large groups of unrelated businesses held under a single corporate umbrella. There were a bunch of rationales for this, including the ability of subsidiaries to raise capital internally, economies of scale in shared functions, and the market and political power associated with size. But one important motive for conglomeration was Markowitz’ portfolio theory. It was argued that a diversified firm faced fewer risks than a specialized one, since when one industry was fairing poorly, other business units might do well to make up the difference.

Conglomerates are no longer fashionable. Investors rejected the case for corporate diversification, because they were perfectly capable of diversifying themselves. Why should MegaCorp include unrelated businesses A, B, and C, when an investor can divide her own portfolio between stock in A, B, and C? In fact, MegaCorp’s diversification harms the investor, because the investor loses the opportunity to customize exposure to A, B, and C according to her own circumstance and expectations.

Unfortunately, most citizens can’t hedge their exposure to nations in the way that investors can diversify investments in firms. This is a strong argument in favor of diversifying at the national level, even when it cuts against maximizing comparative advantage.

There are a several ways that nations may be different than investors that buttress the case for national specialization. Investors choose their investments according to flawed analytical processes, and make mistakes. When a capitalist economy specializes under open trade, it is a vast market that decides in which fields to specialize, what factories to build, what competences to educate. Perhaps owing to “the invisible hand”, “the wisdom of crowds”, or whatever, market economies make such better choices than private investors that there effectively is no uncertainty. The market always chooses correctly, so specialization is the optimal choice. I find this argument unpersuasive, both because I think markets can be short-sighted and mistaken, and because I believe in irreducible uncertainty that no predictive institution can overcome. Another difference between nations and ordinary investments is that national investment has dynamic effects. When a nation begins to specialize in, say, electronics manufacturing, economies of scale and network effects kick in that serve to magnify any original advantage the nation had in that field, and turn the investment into a kind of self-fulfilling prophecy. This, I think, is a quite reasonable point. But the difference between investors and nations can be drawn too starkly. A venture capitalist or angel investor also works, post-investment, to advise firms, to recruit good people, and to create connections between complementary firms. But these kinds of investors still do diversify.

If one buys the case that nations are like investors, and that investors ought diversify in an uncertain world, what does that mean in practical terms? It depends. It might mean nothing. Perhaps the ordinary functioning of national markets produce sufficiently diversified national portfolios on their own, in which case all is well and good. But it does suggest the possibility of market failure. If national investment is skewed or concentrated in some fashion whose future performance (relative to other possible portfolios) is uncertain, public action to promote diversification might be reasonable.

“Industrial policy” is unfashionable, and it is of course true that political processes are flawed and corruptible. The case I’ve made opens the door for rent-seeking operators to seek government handouts in the form of “diversification subsidies”. Any policy based on this argument would have to be designed with great care. Nevertheless, that chemotherapy is poisonous does not imply that cancer does not exist.

Note: While David Ricardo long ago joined Zeus on Mount Olympus, Harry Markowitz, whose work I much admire, is a living, active scholar. The views expressed in this essay are entirely my own, and if I seem to have put words in Harry Markowitz’s (or David Ricardo’s) mouth, I do apologize.

Update History:
  • 06-May-2007, 02:41 p.m. EDT: Neurotically transposed he words “hedge” and “diversify” in a sentence. Also changed a “diversification” to “diversifying”.
  • 08-May-2007, 11:12 p.m. EDT: Changed “approach for” to “approach to”. Grrr.

Gabriel Mihalache on Trade

Though it may come as a surprise to some readers, my aesthetic predilection is towards libertarianism. My politics, alas, have moved beyond pure principle, and are now hostage to the messy business of outcomes, the management of which is, of course, anathema to perfect liberty. Nevertheless, I wish I could agree with this piece by Gabriel Mihalache. Gabriel writes an eloquent statement of the principled libertarian position. His candor is refreshing, about the philosophy, the politics, and the economics of trade. I don’t agree with him. But reading the piece made me homesick. Here’s a taste:

The knee-jerk, crypto-utilitarian reaction is to ask if [trade] improves the life (of the community?) on the net. (Isn’t it magical how “on the net” solves all conflicts between members of the same community?) But that’s not my thing. Any such calculus is philosophically suspect and highly conjectural at best.

A more robust alternative is to ask ourselves… by which interactions do these changes in welfare, the focus of so much debate, come about? And the answer is simple: by a “reshaping” of the decentralized, free trade pattern. Old contracts/associations are simply not renewed, new ones are created.

The “losers” from free trade lose because they can’t get the same trading terms they used to get. Others are no longer willing to associate with them under the previous terms. Is this legitimate? Yes. It’s the basic definition of the freedom of contract, which implies not only the freedom to draw and enter into contracts, but also to choose not to do so (anymore).

Hence, all trades and changes in trades/associations following the opening of borders are legitimate actions. There are no guilty parties. On the other hand, keeping borders closed is a direct violation of the freedom of association.

Innocent free men should not be subjected to coercion and persecution if they choose (not) to associate with foreigners and fellow countrymen alike. This is a basic political principle of any nation that calls itself free, at least in spirit, if not in letter also, but never in practice, it would seem.

Trade is a simple issue. Basic human decency, not to speak of the spirit, if not the letter, of contemporary constitutions demand it.

Is free trade without compensations Pareto inefficient, in the sense discussed here? Yes! But so is breaking up with your girlfriend, quitting your jobs or changing your favorite shop. So what? The Pareto & compensation criteria are at best dubious politics and at their worst, a cheap excuse to obfuscate and obstruct the issue of free trade.

Update History:
  • 05-May-2007, 10:23 1.m. EDT: Fixed embarrassing use of “principal” where I meant “principle”…